After 3 Years of Losses, Stock Funds' Biggest Challenge May Lie Ahead

Times Staff Writer

Leslie Weaver is the kind of investor mutual fund companies respect -- and fear.

The 62-year-old said he never bought into the stock mania of the late 1990s. The bulk of his portfolio is in bond funds.

Weaver has thought a lot about the economy and about how stocks and bonds might fare in the next few years. He likes the views of Bill Gross, the bond guru of Newport Beach-based Pimco Funds:

"Gross says that both stocks and bonds will underperform their long-term averages, but that bonds will be the smoother ride," Weaver said.

The Fountain Valley retiree did invest small amounts in two "value"-oriented stock funds last year -- the Clipper Fund and Dodge & Cox Stock. Despite a sense that Wall Street could take quite a while to recover from the excesses of the bull market, Weaver said he had to allow for the idea that "I may have this figured out all wrong."

But for the most part, his view of the stock market remains very cautious. "I'll go in when I'm ready," he says about investing more money in equities. "But not yet."

For the mutual fund industry, three years of losses in the stock market have hit hard. Based on data through November, stock funds suffered their first year of net redemptions by investors (more money leaving than coming in) since 1988.

As assets shrink, more fund companies are closing or merging funds. Fidelity Investments and Putnam Investments, among other firms, have laid off some employees in the last year.

What the industry is hoping for in 2003 is that more investors like Weaver will step up to make new commitments to equity funds.

What the industry fears is that more investors like Weaver will remain skeptical about the market's prospects and will stay away -- or worse, will pull money out of stock funds altogether.

Redemptions can hamstring fund managers, forcing them to sell stock holdings to meet cash calls by departing investors. That can hurt a fund's performance, generating more misery for investors who stay put.

Net redemptions in 2002 were tiny compared with total stock fund assets: The net cash outflow in the first 11 months of last year amounted to 0.7% of the sector's assets, according to the Investment Company Institute, the funds' main trade group.

But history shows that when investors sour on stocks, they can leave funds in droves. In the late 1970s, as stocks struggled to recover from the deep bear market of 1973-74, more than 10% of fund assets fled every year.

Even if stocks' fourth-quarter rally signals that Wall Street's 3-year-old bear market has ended, fund companies' biggest challenges in holding on to investors may lie ahead, some industry experts say. Here's why:

Over the last two years, nearly every stock fund sector slumped as the bear market raged. That has made it easier for the industry in the sense that portfolio managers could argue that no one could make money in a market so vicious.

At the same time, the worst stock losses in a generation have left many investors frozen in place.

"People have talked about how steadfast the individual investor has been," said Don Phillips, managing director at fund tracker Morningstar Inc. in Chicago. "But I think it's been more paralysis than steadfastness."

Either way the market goes in 2003 -- recovery or more losses -- more individual investors may finally decide to take action in their portfolios.

What could give many investors a big push is if the market stages some kind of comeback, but the gains are uneven. Then, funds that lag in performance, or continue to lose money, will stand out -- and could become targets of investors' ire.

On Wall Street, the most commonly used term to describe the outlook for the next few years is that this will be a "stock picker's market." In other words, it'll be possible to make money, maybe even a lot of it -- if you choose your stocks carefully. But there won't be a sweeping, extended rally to drive shares higher across the board, many say.

That may bring a true test of talent in the stock fund industry. It may also hasten the departure of managers who performed worse than their peer average in the bear market and lag behind in any market recovery.

"There will be a shakeout," Phillips said. In the 1990s, "this industry was built up in anticipation of a long period of sustained growth" in stock values.

Although bond funds enjoyed hefty net cash inflows from investors last year, stock funds still are the business' bread and butter, with $2.8 trillion in assets compared with the $1.1 trillion in bond funds.

Also, fund companies generally earn much higher management fees on stock funds than on bond funds. Fees are charged as a percentage of assets.

Some investors who look beneath the surface of Wall Street performance data for 2002 already may find reasons to doubt the average fund manager's stock-picking talents.

Last year, while the average domestic equity fund lost 22.6%, according to Morningstar, 1,608 stocks on the New York Stock Exchange rose in price as 1,949 fell. On Nasdaq, 1,446 stocks rose as 2,415 fell.

So the odds of picking a winning stock weren't nearly as poor as the performance of major market indexes -- and the average equity fund -- might suggest.

Then why did most fund managers lose money for their investors? A big reason is that most funds focus on the biggest and best-known stocks, in part because those shares can be easily bought and sold in quantity.

And the best-known stocks have been the worst performers for most of the last three years. Consider: In 2002, just three of the 30 blue-chip stocks in the Dow Jones industrial average rose in price.

Some Wall Street pros believe that the market has become more challenging for mutual fund portfolio managers because of the boom in "hedge" funds since the late 1990s. Hedge funds, which cater to wealthy clients, tend to have short time horizons. Those investors are fueling faster moves up -- and down -- in individual stocks and sectors, analysts say.

Brett Gallagher, head of U.S. equities for money manager Bank Julius Baer in New York, believes that the stock market overall is overvalued and headed lower. But along the way, hedge funds and other institutional investors are likely to produce a lot of fireworks with their trading activities, he said.

"I see a lot of rotation among stock sectors," Gallagher said. "My own experience is that my investment horizon has shortened. Clients are looking at the portfolio every quarter or month" rather than taking a longer-term view.

On the flip side, Coca-Cola Co. late last year said it would no longer provide analysts and institutional investors with short-term earnings guidance.

Coke believes the focus on meeting quarterly profit targets gets in the way of managing the business for long-term success.

If more companies follow that trend, it could make mutual fund managers' jobs tougher by forcing them to rely more heavily on their own sleuthing to determine whether a company's business is going well or faces problems that could slam the stock price.

"Without as much information from companies, you would definitely see more volatility" in the market, said Kevin Marder, market strategist at investment firm Ladenburg Thalmann Asset Management in Los Angeles. "You'll see bigger surprises."

Of course, for all the risks facing fund managers in a potentially much trickier environment, the mutual fund concept still is the easiest way for investors to make long-term bets on stocks via diversified portfolios.

And with yields on government bonds and money-market accounts near 40-year lows, it may not take much of a rally on Wall Street to give stock funds a performance advantage over many of the alternatives in 2003.

Even so, the challenge for investors is making sure they're in funds that can produce the returns needed to meet their long range financial goals.

After three dismal years for stock funds, a better market in 2003 may provide investors with more evidence as to whether they own the right funds -- or whether it's time for a change.

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